Tuesday, February 24, 2009

Obama's Apparent Budgetary Orthodoxy Is Actually Good News

The front-page, top right headline in Sunday's New York Times read: "Obama Planning to Slash Deficit, Despite Stimulus," with the sub-headline "Goal is 50% Reduction." My groan was audible. As one of my colleagues put it, it appeared that President Obama was replicating FDR's worst error -- following up his New Deal stimulus with deficit-cutting fiscal austerity measures, thus creating a recession during the long recovery from the Great Depression -- in only one month, whereas it at least took FDR four years before he caved in to his inner budget hawk. This worry seemed especially plausible when it turned out that Obama's planned 50% reduction in the deficit was to happen in only four years. With my heightened concern about Obama's backsliding on so many issues, and my suspicion that his economics team is too orthodox, Sunday seemed to be one of those days when it would be painful to be a macroeconomist who specializes in budget policy.

The article's sub-sub-headline, however, offered some reasons for optimism: "Cuts Are to Come From Iraq Withdrawal and Taxes on Wealthy." As I read the article, I concluded that there is, indeed, less to worry about here than initially met the eye. First, withdrawal from Iraq (which is long overdue on other grounds) is not the kind of spending cut that is likely to harm the economy. Studies have consistently shown that military spending is the least effective way to create jobs and that military hardware is the least job-intensive kind of government spending. With the virtual certainty that the Iraq withdrawal will not actually result in a reduction in the size of the army, there is no possibility of a repeat of the kind of joblessness that greeted so many WWII veterans in 1946. (The postwar recession is often forgotten, but it was a particularly cruel joke on returning veterans.)

Moreover, increasing taxes on the wealthy -- even if one believes (contrary to the evidence) that such taxes harm the long-term growth of the economy -- is highly unlikely to reduce aggregate demand. For the same reason that tax cuts for the rich are not stimulative, tax increases on the rich do not depress the economy (at least in the short run, which is what we need to care about right now). This is especially true in light of the rather small planned increases in taxes on the rich, for example the return of the top tax bracket to 39.6% from 35%. This is hardly the 91% level of the early 60's.

The third -- and most important -- piece of good news within the article was that Obama plans to level off the deficit at 3% of GDP in 2013 and thereafter, "which is the level that economists generally consider sustainable." That is correct. For example, the budgetary guidelines for membership in the EU include not a balanced budget requirement but a 3% annual deficit requirement (along with a limit on overall debt). Given the general expectation that a modern economy can average 3% growth over the long run, adding 3% to the public debt each year keeps the ratio of debt to GDP roughly constant over time, which is a much more meaningful definition of "balance" than the usual definition.

This suggests that Obama might actually be in the process of undoing one of the most foolish errors of the Clinton era. Many people might not remember this, but prior to Clinton's first term it was not the position of the Democratic party that we must balance the budget annually. Clinton, in what came to be his standard capitulation mode, apparently decided that it was too difficult to explain to people why we do not need to balance the budget every year, so he gave in to the fiscal hawks and announced that balanced budgets were the right goal. As it turned out, he (with a lot of help from the dot-com bubble) ended up running surpluses for a couple of years, which unfortunately seemed to validate a very bad policy move. Even at the time, we knew that there was no way that the budget would remain in surplus for the long haul; and reinforcing people's uninformed belief that annual balance was the right goal was sure to make future policymaking even more difficult than it would otherwise be. It has.

It might well turn out, of course, that the economy will not turn around as quickly as Obama hopes. If so, the larger-than-normal deficits will (and should) continue past 2013. Even so, we might already be on the road to understanding that annual balance is not a useful or meaningful goal for the federal budget. If so, that is a major step forward.

12 comments:

1. Is there not validity to the argument that Clinton's ability to reduce the deficit sent good signals to the bond market, thus keeping interest rates down? With the heavy deficits prior to his action, there was a lot of worry about inflation (triggered by heavy government spending), and a flooded world treasury market (driving bond prices down, and interest rates up).

2. Today, although we obviously need short-term stimulus, over the longer-term what happens if China decides to dump treasuries? Isn't it possible that just as we're recovering, a flooded treasury market could drive up interest rates, causing a deficit-induced double dip?

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